Chinese Largesse Supports Euro, But For How Long?

NEW YORK (Dow Jones)–China’s deep pockets are momentarily keeping the euro supported.

But with Greece’s financial future still uncertain even after lawmakers passed an austerity package on Wednesday, and the single currency’s long-term prospects far from assured, Beijing risks learning a lesson about trying to fight a market more inclined to sell than buy.

For months, whispers of “Asian official buying” have permeated markets when the euro fell below certain levels. That talk has kept euro/dollar hemmed into a tight seven-cent range since late May, even as fears of a Greek default make traders disinclined to hold the single currency.

China, the world’s biggest holder of foreign-exchange reserves, has pledged financial support to the distressed euro-zone periphery while touting its economic links to Europe.

There are perils to China’s strategy, however. Most market observers agree that it is never a good idea to fight the market. Just ask the European Central Bank which spent months buying distressed periphery bonds to calm markets–only to have yields surge amid fears of a Greek default.

China holds more than $3 trillion in foreign-exchange reserves, with an estimated 60% of those in dollars. Its strategy toward the beleaguered euro zone helps it accomplish two goals: expanding its global reach and satisfying the need to diversify its vast reserves.

“The market is inclined to sell the euro on rallies [whereas] China wants to buy it on dips,” said Michael Woolfolk, senior currency strategist at BNY Mellon in New York. “It maintains the current range-bound conditions until we get clarification on the long-term outcome for Greece.”

China’s secretive financial dealings and the FX market’s own opacity make exact figures for China’s affinity for euro-denominated assets hard to come by.

Yet analysts point to official data showing that Chinese U.S. Treasurys holdings have fallen by at least $300 billion recently. Analysis of flows by Bank of America-Merrill Lynch shows that monetary authorities have been net sellers of dollars over the past four weeks, translating them into euros.

By looking at the rate of China’s foreign-asset accumulation, Woolfolk estimates that authorities sell about $2 billion per trading session, with roughly a third converted into euros.

That dovetails with research by Douglas Borthwick, a managing director at currency broker Faros Trading.

Based on asset-allocation trends by the China Investment Corporation (CIC), he estimates the country could invest 500 billion euros ($722 billion) overall in Europe over five years, with 20% devoted to euro-zone peripheries. “That would buy a large amount of goodwill and lubricate other sensitive purchases throughout Europe,” he said.

That doesn’t mean China’s largesse comes without limits.

Analysts see a remote but growing possibility of two worst-case scenarios. Greece dropping out of the euro, or fears about insolvency bringing the troubled economies of Spain, Ireland or Portugal to their knees.

If either of those come to pass, it may give China pause about throwing good money after bad.